Beware of Future Shocks

April 05, 2001

By Christopher Farrell Remember how worrisome was the financial crisis that spread from Asia to Russia and Latin America toward the end of the 1990s? Many rightly feared that the rapid collapse of emerging markets would engulf the world economy, although the tide of despair was eventually stanched by coordinated interest-rate cuts by the leading industrial nations and a debt-forgiveness program.

A few years later, the U.S. economy has stumbled at a rapid pace, and the concern is that an U.S. downturn will spread to the rest of the world. The timing remains murky, but a round of rate cuts engineered by the Federal Reserve and the prospect of a federal income-tax cut might avert the worst.

Nevertheless, it seems we should increasingly expect these abrupt lurches in the world economy. The specific events triggering a major economic shock will differ -- from panicky investors to crony capitalism. Government policymakers will react to the upheavals with more or less skill.

CERTAIN LOGIC. Luck will play its familiar role. Yet, a certain logic unites the international economic crises of recent years: Too much global capital seeking high returns is chasing too few good worldwide investment opportunities. This underlying imbalance between capital supply and investment opportunity means dangerous shifts in the global economic fundamentals are bound to happen.

Take the Asian crisis. Investors lost confidence in the Thai baht, and the financial fallout rippled throughout the world financial system. Investors recoiled in revulsion at evidence of systemic bureaucratic corruption. Yet the basic economic problem was an historic investment and building binge in the emerging markets that created far too much productive capacity in everything from semiconductors to autos. Money poured into thousands of poorly conceived manufacturing and construction projects. European banks, battered by anemic returns on the Continent, were especially aggressive lenders.

Similarly, capital spending in the U.S. soared from the mid-1990s on as business embraced the economic promise of the Internet. The productivity-enhancing potential of computers, software, and telecom gear also allowed companies to produce more and more goods and services despite tight labor markets. Investors sought out high returns in everything from Internet startups, high-tech initial public offerings, and record venture-capital deals.

A goodly number of the bad investment ideas were funded, and we're still coping with the fallout from the great investment boom. "The primary near-term problem," says James Paulson, chief investment officer at Wells Capital Management, "is an overly productive laborer and excess supply capacity caused by overinvestment during the past five years."

HIGH-SAVINGS YEARS. What accounts for the imbalance between capital supply and investment opportunity? Demographics are one factor. The share of the developed world's population in its high-savings years -- ages 45 to 64 - is expected to jump from 39% only a few years ago to some 45% by the end of this decade. These people are eager for high returns on their savings so they can live well in retirement.

Low interest rates play a role, too. Despite the recent concern about a pick-up in inflation, we live in a world of relative price stability. Central bankers, while far from omniscient, have learned over the decades what it takes to run a sensible monetary policy. The real source for price stability is rapid technological innovation, however.

China is likely to exert enormous downward pressure on prices as it becomes a bigger player in the world economy in coming years. In this environment, interest rates will stay down, and investors will search for higher investment returns in higher risk investments, such as emerging markets and telecom gear.

Finally, add into the mix this factor: The economic and income gap between the major industrial nations, especially the U.S., and the rest of the world continues to widen. For instance, from 1870 to 1985, the ratio of the richest to poorest countries increased sixfold.

RICH COUNTRIES GET RICHER. The average income gap between the richest and the poorest countries grew almost ninefold, from $1,500 to $12,000, after adjusting for inflation, according to a paper written by economist Lant Pritchett for the World Bank. Yes, the world has become a much richer place over the past century, but economic growth among the major industrial nations unexpectedly exploded in recent decades. The lack of good investment opportunities in the developing world keeps too much capital trapped in the developed world and, at the same time, disappointed whenever it travels to the frontier regions of the world economy.

Some hopeful signs are emerging that this dangerous global imbalance will ease with time. China, India, and much of the developing world are embracing more open borders and private sector investment. Information technologies are knitting national economies closer together. And there's greater recognition of the need to educate populations throughout the global economy.

Taken all together, better investment opportunities may emerge in the developing nations for the savings of the industrial countries, and that would be good for everyone. But in the meantime, stay alert for the economic crises that can gyrate global stability. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online